Negotiation, Organizations and Markets Research Papers

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1 Negotiation, Organizations and Markets Research Papers Harvard NOM Research Paper No Transparency, Risk Management and International Financial Fragility Mario Draghi Francesco Giavazzi Robert C. Merton This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection::

2 Transparency, Risk Management and International Financial Fragility Mario Draghi (Goldman Sachs), Francesco Giavazzi (IGIER, Bocconi and CEPR) and Robert C. Merton (Harvard Business School and Integrated Finance Limited) September 24, 2003 An earlier version was presented under the same title as the Geneva Report at the Fourth Geneva Conference on the World Economy: Financial Markets: Shock Absorbers or Shock Creators?, International Center for Monetary and Banking Studies, Geneva, Switzerland, May 10, To appear in Financial Stability Review, Bank of England, December Aid from the Centre for Economic Policy Research and the Swiss National Science Foundation is gratefully acknowledged. We thank Alberto Giovannini, Charles Goodhart, Michael Mussa and Elu von Thadden for their comments on an earlier draft, and Agostino Consolo for helpful assistance. Francesco Giavazzi thanks the Houblon- Norman Fund at the Bank of England for its hospitality while part of this work was conducted.

3 1. Risk and transparency Well-functioning financial markets carry out many tasks: the transfer of value over time (borrowing-lending), across borders and industries, the facilitation of payments, the fragmentation of large-size investment projects. An important latent function of financial markets is to provide timely information: on the expectations of economic agents and on the value of the economy s assets. But perhaps the foremost function financial markets perform is the transfer or allocation of risk among different actors: young people, for instance, tend to be better equipped in taking on risk than old people. Given a total amount of risk in the economy, financial markets and financial institutions contribute to its distribution among different actors in a way that better fits individual preferences or conditions. Financial markets, however, are often incomplete, in the sense that they provide only limited possibilities to shift risk across individuals. The role of swaps and other privately negotiated derivative instruments is to complete financial markets, thus increasing the ability of individuals, financial institutions, corporations and governments to manage risk. 1.1 Risk and derivatives Consider, for example, an emerging market economy. The domestic financial market will typically allow very limited diversification of risks. In such a situation, diversification through international capital mobility is the obvious alternative. However, the transfer across borders of the ownership of real and financial assets is a rather inflexible way to achieve diversification, in the sense that it is costly to reverse. Often it also runs against political constraints. Over-the-Counter (OTC) derivative contracts provide an appealing alternative. Equity swaps, for instance, allow a country to diversify risk without shifting the ownership of assets. For example, a government could impose tight capital controls, limit foreign ownership of 1

4 domestic firms and still diversify the country s exposure to domestic risk through equity swap contracts with foreigners that do not require the transfer of ownership of the underlying asset. The general point is that risk diversification through derivative instruments is more flexible than diversification through the transfer of assets. Interest rate swaps, for instance, one of the most common of these instruments, allow banks to service both their borrowers, who want fixed-interest rate, long-dated loans and their depositor lenders, who do not wish to be exposed to interest rate risk, without the bank taking interest rate exposure itself. Creditdefault swaps allow a bank to swap credit risk vis-à-vis one borrower for credit risk vis-à-vis a different set of borrowers: the risk-return performance of the bank may thus be improved without negatively affecting its relationship with customers as might happen if the bank were to sell the loans. We discuss these instruments further in Section 6 of this paper. A volatile economic environment increases the incentive to use derivatives to achieve a better allocation of risk in the economy. During the first half of 2002, as uncertainty in the world economy was increasing, the size of the OTC derivatives market (foreign exchange, interest rate, equity-linked and commodity contracts), increased by 15 percent, reaching $127,564 billion. Outstanding credit derivatives, a type of instruments, which did not exist up to the mid-nineties, increased 35 percent, reaching $1,600 billion. 1 As derivatives markets expand, however, so do the concerns regarding the possibility that the use of these instruments might increase the vulnerability of the financial system, rather than contribute to a better allocation of risks. These concerns were well summarized in a recent IMF paper: OTC derivative contracts bind institutions together in an opaque network of credit exposure, the size and characteristics of which can change rapidly and, moreover, are arguably not fully understood with a high degree of accuracy even by market participants themselves. Risk assessments and management of exposures are seriously complicated by a lack of solid information and risk analyses about the riskiness of both their own positions and those of their 1 Data from the B.I.S. and the International Swaps and Derivatives Association. 2

5 counter-parties. As a result this market is characterized by informational imperfections about current and potential future credit exposures and market-wide financial conditions. 2 The collapse of Enron and the view that the company s use of derivatives was a factor in its demise a view by no means uncontroversial, as discussed in ISDA, only added to these concerns. Discussions of the role of derivatives and their risks, as well as discussions of financial risks in general, often fail to distinguish between different types of risk. To understand the breeding conditions for financial crises the prime source of concern is not risk per se, but the unintended, or unanticipated accumulation of risks by individuals, institutions or governments including the concealing of risks from stakeholders and overseers of those entities. To make this point, the paper analyses specific situations in which significant unanticipated and unintended financial risks are accumulated. Among the examples concerning the public sector are the explicit and implicit guarantees that governments extend to banks and other financial institutions. Such guarantees can be the source of unrecognised accumulation by governments of unanticipated risks and resulting liabilities in the balance sheet of the public sector. 3 We shall analyze how the value of such guarantees changes with the change in the value of the economy s assets, and what this implies for a government s financial policy, and thus for the sustainability of the public debt. This analysis will naturally lead to a set of reflections on the correct evaluation of a country s exposure to risk and on the design of prudential rules for banks and for their shareholders. It will also lead to a discussion of the way financial instruments, such as swaps, could be used to control the accumulation of risk. 2 Schinasi, Garry, J. et al. (2000, p. 50). The paper provides a thorough review of the problems associated with the use of derivative instruments. 3 These unexpected outcomes of economic actions are specific instances of the more general concept of unanticipated consequences of social actions. See R. K. Merton (1936, 1989). 3

6 1.2 Transparency and accounting principles There are situations where the unintended, or unanticipated accumulation of risks may be a sheer consequence of inadequate accounting principles that conceal risk itself. An important example of the limitations of standard accounting principles in identifying and revealing large risk exposures is offered by the treatment of company pension funds a topic we take up in the next section of the paper. The demise of Enron has attracted much attention on the lack of transparency of leverage and risk-taking by firms that move liabilities and risk exposures off their balance sheets by using complex special-purpose partnerships and derivatives. The same financial engineering tools that have served well in the efficient transfer of risks across otherwise incompatible institutional systems, may also be used to disguise large risks and value losses from even the most diligent of detectors. The danger of abuse, and thus a need that corporate managers, board members and other external overseers understand these instruments, has been rightly emphasized following the Enron events. Indeed, the boards of many firms are engaging outside risk specialists to search for what they call Enronitis among their subsidiaries and capital structures. However, this bright-light focus on modern financial technology can blind us to more fundamental issues surrounding the limitations of traditional accounting. One need look no further than to the familiar, plain-vanilla, well-understood defined-benefit corporate pension plan as an example of these limitations. Such plans present a far larger in magnitude and more widespread off-balance sheet leverage, than any of the Enron transactions, and without reliance on complex derivative contracts at all. 4

7 2. Risk and (lack of) transparency in U. S. balance sheets: the economic effects of the accounting treatment of defined-benefit pension plans A defined-benefit (DB) pension plan represents a secured claim by the plan s beneficiaries against the company typically a guarantee of a pension of up to two-thirds of final salary. The plan s assets constitute collateral-like security for promised benefits. From an economic standpoint, this is equivalent to the company borrowing money to invest in assets. For this reason a company that does not wish to use the defined-benefit pension plan it sponsors to increase its asset risk and its leverage should invest 100 percent of the plan s assets in highly rated, fixed-income, securities, the duration of which matches the duration of the plan s liabilities. This however is not what most companies do GAAP rules and companies exposure to risk via the pension plans they sponsor Generally accepted accounting principles in the United States (GAAP, Statement of Financial Accounting Standards No. 87, SFAS 87) direct public companies that sponsor a defined-benefit (DB) pension plan to report, in their balance sheet and income statement, only the net difference between the company s pension assets and liabilities, as a corporate asset or liability. Thus what enters the company s balance sheet is only the surplus (deficit), which is the difference between the value of the plan s assets and its liabilities. For example, a plan with $65 billion in assets and $64 billion in pension liabilities would report a net amount of surplus of $1 billion, the same as a plan with $2.5 billion in assets and $1.5 billion in liabilities. The amount of risk a company accumulates in its balance sheet, via the exposure to its pension plan, thus is not immediately visible. Table 1 shows the balance sheet of a hypothetical company that sponsors a DB pension plan. The case shown in the table is that of a company whose plan is fully funded that is, at current market prices assets and liabilities are matched. This of course would not be the case if, for instance, interest rates subsequently changed. 5

8 Table 1 Balance sheet of a company sponsoring a defined-benefit pension plan (The case shown is that of a company whose plan is fully funded) Assets Liabilities Capital - Equity - Debt off-balance sheet: Pension Fund Assets: DB Plan Liabilities - Bonds Stocks 60 For example, if the pension plan s assets are partly (for the typical U.S. plan around 60%) invested in stocks, then a simultaneous fall in both interest rates and stock prices as might happen during a recession or in a financial crisis with a flight to quality would increase the value of the plan s liabilities which rise as interest rates fall and at the same time reduce the value of the assets held as collateral for those liabilities. The company s economic balance sheet is thus exposed to the volatility of the plan s assets and liabilities. 5 The accounting treatment of a DB pension plan is thus little different from the treatment of an off-balance-sheet long-dated swap derivative contract in which the company receives the total return on an equity portfolio and pays a fixed rate of interest in return applied to a notional amount equal to pension liabilities. 4 For an extended discussion see Bodie, Mitsui and Tufano (2002). 5 We believe that the correct way to compute the value of a plan s liabilities is to use the yield on a longterm default-free bond as the discount rate since in this case liabilities are valued using a discount rate that has the same risk and timing characteristics as the payments the plan will make. This belief, however, is not undisputed. When stock markets fall, some actuaries hold that the fall in asset prices does not matter for the solvency of a pension plan, because, as share prices decline, the dividend yield rises and the expected return on the market increases. Accordingly, as the assets decline, so does the actuarially measured values of the liabilities assuming this is computed using the dividend yield, as discount rate. 6

9 Therefore, a standard U.S. corporate pension plan may produce the same leverage and potentially large risk, as would the use of an equivalent derivative contract, with neither directly reported on the balance sheet. 2.2 Pension plans, income statements and bonuses GAAP rules allowing a company to account for the surplus income from its DB pension plan as operating income, can obscure any assessment of the company s performance. Consider, for example, a good-performing year, that is a year in which the return on the pension plan s assets is particularly good and exceeds what would be required to match the increase in the plan s liabilities. GAAP rules allow this excess return to be credited as a new intangible asset, called prepaid benefit expense. The opposite adjustment can be made in a bad year. The beneficiaries of excess return are not the plan s beneficiaries, but the company s shareholders who can draw on this intangible asset to top up the company s net income. For example, in 2001 Verizon Communications Inc. reported a net income of $389 million, after taking losses for a variety of telecom investments. The true net income, however was a loss of $1.8 billion: The net income was turned positive by drawing on the excess return on the assets of the company s pension plan. Milliman USA, a benefits consulting firm, reports that in 2001 the net income declared by 50 large U.S. corporations included $54.4 billion of excess returns from pension funds assets. In fact, these assets lost $35.8 billion. 6 Discretion on the part of companies in their treatment of the returns on pension fund assets, and thus lack of transparency, extends far beyond. Keeping to the Verizon example, if one looks more closely at the company pension plan, one finds that in 2001 the return on the plan s assets was negative, and resulted in a reduction in the value of total assets amounting to 6 7

10 $3.1 billion. How then could the company claim an excess return and report it on its income statement? GAAP rules are based on the assumption that over time positive and negative returns on a pension plan s assets will balance out. A company s accounting is thus expected to understate both its plan s losses in bad years and its plan s gains in good years. In economic terms shareholders should benefit from the pension plan s income with smaller contributions in good years, and pay more into the plan in bad years. This is not what always happens in accounting terms. Verizon s 2001 income statement assumes that its pension plan had earned a return of 9.25 percent and it reported income as if that assumption were true. Other companies made even more bold assumptions: IBM assumed a return of 10 percent, General Electric of 9.5 percent. In Verizon s case, the income associated with a return of 9.25 percent would have exceeded the amount required to balance the increase in the liabilities of the company s pension plan: thus the origin of the excess return. The incentives to legally manipulate the return on a company pension plan are enhanced by the practice of including the income assumed to have been originated from the pension plan s assets when computing management s performance bonuses. However, when a plan slips into underfunded status as might happen when the fall in asset prices and interest rates do not reverse and eventually must be recognized in the company s accounts a corporation s equity may take a hit that can disproportionately exceed the year s charge to the DB pension plan. This is because SFAS 87 requires a corporation whose plan falls into unfunded status to take two actions:. charge to the balance sheet a minimum liability equal to the amount underfunded. Thus, for a pension plan for which the minimum liability is required, all losses of the plan for the year including the full effect of higher liability measured at the new lower interest rates and asset losses in the weak markets are immediately reflected as reductions in shareholder equity; 8

11 . cancel any asset that had been created in the corporation s balance sheet as a result of the accumulation of excess returns on the pension plan s assets during the previous years. The charge for such cancellation is taken by shareholders equity. To illustrate, assume a plan was previously overfunded, generating a positive contribution (negative annual cost of the plan) to the income statement in prior years. These positive contributions appear as a prepaid pension cost, an asset item on the company s balance sheet. Now assume that the plan is no longer overfunded due to investment losses and/or an increase in obligations. The consequence of the minimum liability calculation is that:. the prepaid pension cost (an asset) must be eliminated, and. an accrued pension cost (a liability) equal to the amount of underfunding must be carried on the balance sheet. The combined effect of these changes can be a significant adjustment to shareholder equity as illustrated in Table 2. Note that in this example, the company s equity is reduced not merely by the $1,000,000,000 underfunding, but by the reversal of the entire previously accumulated prepaid pension cost as well. Table 2 Balance sheet effects of the minimum liability requirement in the case of unfunded DB plans (U.S. $ billion) Initial Adjustment for Final Measurements Minimum Liability Figures Accumulated benefit obligation Assets Unfunded 1 1 Accrued/(Prepaid) pension expense Note: The U.S. $ 6 billion adjustment is treated as a direct reduction in shareholder equity. 9

12 2.3 The transfer of risks onto the government GAAP accounting principles thus conceal on a year-on-year basis a company s true exposure to market volatility, which should include the substantial exposure acquired through the assets and liabilities of its pension plan. Full disclosure, on corporate balance sheets, of the composition of a pension plan s assets (or, in the absence of it, continuous matching of the mark-to-market value of the plan s assets with that of its liabilities) would reveal the true degree of the company s leverage and risk. This is not something that is being considered in current proposals for an overhaul of GAAP rules. 7 How widespread is the problem? For many of the largest 50 U.S. companies (see Table 3) DB plans account for the bulk of the company s pension plan assets. The remaining pension assets are accounted for by defined-contribution plans, such as 401(k). These assets collectively can be a multiple of the company s market capitalization. In December 2001 the pension assets of General Motors, the largest corporate pension plan in the United States with over $73 billion in defined-benefit plan assets, were 2.7 times the company s stock market value. As inspection of Table 2 reveals, GM is certainly not alone in this position among U.S. corporations. Corporate pension assets in total represent a significant fraction of the overall market value of U.S. corporate equity, over one-fourth. Sixty percent, on average, of the assets of defined-benefit plans are invested in common stocks: the fraction has increased from about 50 percent in the 1980 s. 8 As long as the company is solvent, the risks and rewards of allocating the plan s assets to equities are borne by shareholders, since the fund s beneficiaries enjoy a defined benefit with no upside. However, if the company were to go into bankruptcy, the risks are transferred in part to the beneficiaries, and in part to the federal government through the Pension Benefit 7 For a proposal in this direction see Peter Hancock and Roberto Mendoza Risk and Transparency in Pensions, Financial Times, March 20, 2002, page GM announced In January 2003 that its pension fund assets were unfunded by $19.3 bn, compared with $9.1 bn a year earlier (Financial Times, January 10, 2003, page 21.) 10

13 Guarantee Corporation (PBGC), the government institution offering partial guarantee to the beneficiaries of the companies DB plans. Therefore, when a company invests the assets of its pension plan in common stock it is de-facto raising its leverage, and transferring, at least in part, the risk onto the plan s beneficiaries and onto the government. Negative shocks to the corporate sector can thus be transferred, through company pension funds to the government. An example is shown in Table 4. We assume that the pension plan (a DB plan with government guarantee) is invested 50% in equity. A negative shock to the corporate sector reduces the value of its assets by 40 percent, causing a 30 percent fall in equity. The fraction of the pension plan s assets invested in equity also falls by 30 percent. In a DB plan the liabilities are unaffected by the shock. Therefore the government s financial exposure to the plan increases by a corresponding amount. The effects of the transfer of risk onto the government are apparent in the balance sheet of the PBGC for the year ended on September 30, During this period the operating loss of the corporation amounted to $3.64 billion, an $11.37 billion net turnaround from a $7.73 billion surplus a year earlier, the largest in the federal pension insurer's 28-year history. Of these losses, by far the largest fraction, $9.31 billion, is accounted for by the increase in Claims for actual and probable pension plan terminations, that is for the pension obligations transferred to the PBGC by company plans in default, plus the increase in the value of the guarantees extended. This loss arises because, under GAAP, the PBGC recognizes as a loss both actual and probable pension plan terminations. During fiscal year 2002, $5.91 billion of the $9.31 billion in losses were from "probables." Since the close of the 2002 fiscal year, the agency has assumed full responsibility for the pension plans of two companies-national Steel and Bethlehem Steel-that together accounted for $5.16 billion of the losses estimated as probable on September 30. Another key factor was the decline in interest rates, which increased the program's liabilities by $1.65 billion. 9 The balance sheet is available at 11

16 3. Balance sheets and financial guarantees 10 The pension-plan example shows how the government can become exposed to shocks that originate in the private sector. Financial guarantees can transfer risk across different sectors in the economy and also produce negative feedback loops that can trigger severe crises. In this section we develop this theme further, showing how the implicit guarantees governments extend to banks and other financial institutions result in the accumulation, often unconscious from the viewpoint of the government, of unanticipated risks in the balance sheet of the public sector. 3.1 Loans and guarantees Any time a bank makes a loan, an implicit guarantee of that loan is involved. To see this, consider the following identity, which holds in both a functional and a valuation sense: Risky Loan + Loan Guarantee Default-free Loan this can also be re-written as: Risky Loan Default-free Loan Loan Guarantee Lending by a bank thus consists of two functionally distinct activities: pure default-free lending and the bearing of default risk by the lender 11. This equivalence of course applies more generally to other forms of debt obligations, not only to bank loans. Whenever a lender makes a loan to anyone other than a default-free government, he is implicitly also selling a guarantee. 10 This section draws heavily on Merton and Bodie (1992) 11 This identity strictly applies only if (a) the guarantee itself is default-free, and (b) it covers the entire loan. That is, the guarantor will not default on this obligation, and his obligation is to fully make up for any loss on promised payments. Some guarantees have deductibles, or require co-insurance with the debt holder. Tax treatments and other regulatory factors could also affect the identity. While such factors are important in analyzing specific situations, they are not essential in understanding the fundamental functional activity of lending as discussed in the text. 14

17 To see this point more clearly, it will perhaps be helpful to think of the lending activity as taking place in two steps: i. purchasing a guarantee, and ii. taking up of a loan Suppose that the guarantor and the lender are two distinct entities. In the first step, the borrower buys a guarantee from the guarantor for, say, $10. In the second step, the borrower takes this guarantee to the lender and borrows $100 at a default-free interest rate of, say, 10% per year. The borrower winds up receiving a net amount of ($100 - $10 =) $90 in return for a promise to pay back $110 in a year. Often, of course, the lender and the guarantor are the same entity for example, a commercial bank and the borrower simply receives the net $90 from the bank in return for a promise to repay $110 in a year. The interest rate on the loan is then stated as 22.22%, i.e., ($110 - $90)/$90. This promised rate reflects both the risk-free interest rate and the charge for the guarantee. To see that the two are separable activities, note that the holder of the risky debt could buy a third-party guarantee for $10, as shown in Table 5. The holder would then be making a total investment of $90 + $10 = $100 and would receive a sure payment of $110. Table 5 The balance sheet of a bank that issues guaranteed debt (units are in $) Assets Liabilities Risky asset 90 Guaranteed debt 100 Guarantee 10 15

18 The purchase of any real-world loan is thus functionally equivalent to the purchase of a pure default-free loan and the simultaneous issue of a guarantee on that loan. In effect, the creditor simultaneously pays for the default-free loan and receives a rebate for the guarantee of that loan. The magnitude of the value of the guarantee relative to the value of the defaultfree loan component varies considerably. A high-grade bond (rated AAA) is an almost defaultfree loan with a very small guarantee component. A below-investment-grade or junk bond, on the other hand, typically has a large guarantee component. 3.2 Transferring risk onto the government The liabilities that banks issue to fund their lending are often guaranteed by the government--typically through deposit-insurance schemes. Here we analyse the effects of these guarantees for the public sector. In particular, and more importantly, we wish to understand how does the risk exposure of the government change as the value of the banks assets changes? Table 6 shows the balance sheets for a corporation, for a bank that holds its debt, and for the government. The bank itself is financed in part with debt, in part with equity: the value of the debt, if its promised payments were risk-free, is $90. In panel A) there is no guarantee, therefore the debt is risky: its market value is $85, lower than its default-free value of 90. This is because, as in the example discussed above, it reflects the prospect of a lower-than-promised payment in the event of default. In panel A) the government is not involved in guaranteeing the bank: its balance sheet is balanced with assets and liabilities both equal to A. Next we examine, in panel B), what happens following a shock which reduces the capital of the corporation, and thus also the market value of the bank s asset. The loss is absorbed in part by bondholders and in part by the bank s shareholders say a third by the former, and two-thirds by shareholders. The market value of the debt falls to $82 = $85 - $3; the bank s equity to $8 = $15 - $7. The government s balance sheet is again unaffected. 16

19 Now let us introduce a government guarantee that makes the bank s debt risk-free. This is shown in panel C). Before the shock, when the capital of the corporation is worth $200, and the bank s assets are worth $100, the value of the guarantee is $5, exactly the amount of the default discount on the non-guaranteed debt. Since the debt is fully guaranteed by the government, the value of shareholders equity does not change. In the balance sheet of the bank the guarantee is an off-balance-sheet item (this is why we write it below the line ), but its value is fully reflected in the equity of the shareholders. Finally, the guarantee shows up in the government s balance sheet as an additional liability: here too we write it below the line, to reflect that such guarantees are seldom accounted for in the government s books. 12 The guarantee protects the debt from the effects of the shock to the corporation s balance sheet. This is shown in panel D). Equity falls to $8, as in the absence of the guarantee, while the market value of the debt does not move from its risk-free value, $90. This of course is possible because the value of the government s guarantee has risen from $5 to $8, an increase that matches the loss that the debt would have incurred absent the guarantee. The government s balance sheet now reflects the greater value of its guarantee to the banks. The government s exposure to the guarantee changes, as the value of the underlying variables change. This is because the government guarantee protects the debt from the effects of any shock to the corporation s balance sheet. In the last panel of Table 6, panel E), we examine by how much would the value of the guarantee rise, following a further shock to the capital of the corporation, one that reduces it to $120, a further loss of $40. The decline in the value of corporate assets increases the prospect of a default and a lower-than-promised payment to the bank: this reduces the value of the corporation s debt to, say, $75. The value of the corporation s equity thus falls to $45. Now consider the balance sheet of the bank. Absent the guarantee, the market value of the bank s debt would have fallen, 12 In the United States, the Office of Management and Budget is supposed to estimate the value of all guarantees issued by the government. 17

20 say, to $73 and the bank s equity to $2. The government s guarantee protects the value of its liabilities: it thus amounts to $17. In our examples, the relative proportions in which a fall in the value of the bank s assets is borne by debt and equity--or by equity and the government guarantee-- were simply given exogenously. Understanding the underlying structure and variables that determine the increase in the value of the guarantee, as the capital of the corporation falls, will assist our understanding of how governments, by guaranteeing the bank s debt, can accumulate unanticipated risks--and why even recognizing the liability incurred at a given point in time on a marked-to-market basis is not enough to fully capture the government s changing risk exposure. 18

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